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Price Review MechanismsFor multi-year contracts in MRO

White PaPeR

– Paul Mazlin

external Document © 2014 infosys Limited

1. Lose now, gain later: Pitching prices

lower to win the tender then recouping

the lost margin later via

the PRM

2. Ambiguity: PRMs that are poorly

defined leading to ambiguity in the

suppliers favour. an example of this is

when a PRM is described in words rather

than as an algebraic expression

3. Diversion: PRMs that include indices

that are not highly correlated to their

input costs but which can be relied

upon to increase prices – eg the

consumer price index (CPi)

4. Smoke & mirrors: PRMs that are

completely opaque and thus beyond

commercial scrutiny such as a list minus

pricing structure where the list price is

“secret” and cannot be viewed

5. Bamboozle: PRMs that are so

complicated that they bamboozle the

customer into acceptance

6. The only way is up: PRMs that only rise

but never fall

7. Rate of change arbitrage: this tactic is

to use an input to the PRM that moves a

lot faster than the cost base to create a

type of arbitrage opportunity until the

supply chain costs catch up

8. Data and statics: the choice of data

source and various statistical methods

can be used to skew the value of input

data to a PRM. For example in iron ore

does one use the contract price or the

spot price? in foreign currency, do you

use the rate from a bank or from an

independent data provider? and which

method of calculation is to be used ie

the spot price, simple average, moving

average, exponential moving average –

and over what time frame? all of these

elements can greatly influence the

functioning of the PRM and should be

taken into account

On the supplier side, a poorly constructed

PRM can also be disastrous. By way of

example, while working with a mining

contractor in July 2008, oil shot to $US145/

33%

10.0

2012Inital �xed

price period

20131st price

review period

20142nd price

review

10.511.0

67%

+5%+5%

Figure 1: three Year Contract example - $10M annual spend with +5% annual price increase

this example illustrates that for a three

year contract, ~68% of spend is controlled

by the PRM – ie all spend in 2013-14. the

example is based on an annual spend

of $10M and a price increase of 5% per

year, assuming that quantity remains

constant. if quantity is growing, then the

proportion controlled by the PRM can

increase substantially making it even

more important.

Savvy suppliers often use a variety of tactics and strategies to covert ly increase their

margins while under contract and are generally along the following them es:

introduction

When companies undertake tendering

events, a significant focus is on pricing

and cost reduction as you might expect.

however, for a typical three year contract,

improved pricing might only apply for the

first twelve months leaving the remaining

two years of the contract to be governed

by the Price Review Mechanism (PRM).

if the volume remains constant then

the price review mechanism will govern

at least 66% of the contract value as

illustrated below. Yet in industry, we do not

see a significant focus on PRMs given the

power they wield over the contract value.

in fact, often we see quite the opposite

with the PRM being an afterthought to

the main game of obtaining here and now

price reductions. this white paper seeks to

inform readers about some of the theory

and best practice around PRMs and some

of the most popular value destroying

strategies and tactics to look out for.


barrel. as expected, the price of diesel also

shot up and the contractor scrambled for

their PRM with the hope of passing on

the extra cost to their customers. to their

horror, their PRM only allowed them to

increase prices every four months and only

in line with the australian Bureau of Statics

(aBS) Producer Price index. Further, the

aBS Producer Price index moves slowly and

is an average of many costs – not just the

fuel. the result was massive losses which

would have broken the company, had

they not been permitted to declare Force

Majeure (Force Majeure is traditionally

declared after natural disasters – not

manmade economic disasters). all this

drama was purely the result of a poorly

designed PRM that did not allow them to

adequately pass on input pricing shocks

such as this. in this example the PRM did

not accurately match the input costs of the

service being provided nor did it include

any provisions for passing on extreme cost

increases. this left the contractor exposed

to large and unexpected risks that were

way beyond its control - a painful lesson in

risk management.

the 2008 oil price spike rewarded those with solid PRMs by allowing the increased costs to be passed on to customers but many companies were left fully exposed only to see their profits rapidly evaporating and losses begin accumulating. Renegotiating with customers or attempting to declaring Force Majeure became the only option for many companies in the mining and transport sectors

Crude Oil Price-$US per barrel140

120

100

80

60

40

20

2002 2004 2006 2008 2010 2012

0

Figure 2: the oil price shock of 2008 Source: http://www.indexmundi.com

Price Review – the theory

So what is a PRM trying to achieve? if you

consider that a tender process essentially

results in an agreement with a supplier on

their margin, then a PRM is an attempt to

lock in that agreed margin over a longer

period for which it is not practical to fix

prices – ie three or more years. the theory is that the PRM will preserve the benefits from the sourcing exercise, rather than see them slowly erode over the subsequent years of the contract. We could avoid needing a PRM entirely if we just created a one year fixed price contract. however, this is not practical due to the significant effort required to conduct a tender process and implement a supply contract. Secondly, by offering a three year term, the volume of spend is aggregated and this becomes more attractive proposition to suppliers who will

then hopefully be encouraged to provide competitive pricing.

PRMs can also be thought of as a risk allocation mechanism. When a supplier agrees to a fixed price period they are essentially taking on all the pricing risks in their supply chain even if their costs dramatically change. to accept such risks, companies typically add a significant risk premium. in our experience, a better way to address this type of situation is not to expect suppliers to accept significant unquantifiable risks but instead, to collaboratively design a PRM that allows suppliers to pass on or share this risk and in the process, minimise or eliminate the risk premiums.

a typical method of managing risks is to

set tolerance bands for the various indices

or data used in the PRM. Contractual

wording can then establish that a price

review event shall only occur if there has

been movement in the indices or economic

data larger than the predefined limit eg

+ -1%. the wording can also specify if the

price review can occur at times other than

the nominated price review periods if the

limit is breached.

the aim of this exercise is not to shift all

possible risks onto the supplier. Shifting all

risk to the supplier typically results in the

suppliers adding significant risk premiums

or even losing money on a contract which

leads to a drop in quality and service or

bankruptcy in the extreme. a best practice

PRM is equitable and allocates specific risks

to the parties that are best positioned to

manage those risks and therefore at the

lowest risk premiums.


33%

Inital sourcing event

Sourcing costreduction

1st pricereview

2nd pricereview

67%

Tota

l Cos

t

Time

types of PRMs

Best practice PRMs use algebraic formulas

to model a product’s input costs using

publically available data such as indices

from the aBS. algebraic PRMs are optimal

since there can be no argument from either

party and thus the price can be reviewed

quickly and easily without any negotiation

or debate. however, algebraic PRMs are not

always possible which is where the ‘open

book’ style of PRM is useful.

Algebraic PRM Approach

the algebraic approach is to divide the

price into its individual components

and then consider the mathematical

relationship between the major cost

drivers for each cost component. a PRM

can then be devised around these drivers

and weighted accordingly. Figure 3: annual contract cost for a three year contract with annual price reviews after a sourcing event.


New price = Existing price x 60% x Current wages indexPrevious wages index

+ 40% x Current steel indexPrevious steel index

Figure 4: a multiple index PRM for an item consisting of 60% labour and 40% Steel

Open Book approach

MRO categories often contain thousands

of different products such as industrial and

electrical consumables and it is simply not

possible to create an elegant algebraic

PRM that will work for all items. in these

situations, the ‘Open book’ method can be

used. this approach operates such that the

supplier must propose any price increases

to the customer for approval. all proposed

price changes must be directly related to

specific supply chain price changes and

often the supplier is required to present

supporting evidence of any such claims

– ie open their books for scrutiny. this

approach puts the onus on the supplier to

justify any price changes but this approach

is much less robust than an algebraic PRM

and each price changes request becomes a

negotiation.

the ideal situation is if the supplier has a

published list price or list prices published

on their website. the significance of this

is that since the raw list price is published

and visible to the market, there will be

competitive forces at work which will

naturally act to limit price increases. in this

situation, the supply contract can be setup

as a simple list minus discount regime

using the public list price as the basis. But if

the list price is not publically available then

this type of list minus approach becomes

opaque and meaningless.

a recent example of this was found in

equipment hire where the price list for the

hire equipment was not freely published

but instead, when each customer logs

in to the company web site, the prices

presented are automatically adjusted

according to their agreed discount

structure but the undiscounted list prices

are not shown. So, in effect, the customer

can never actually see the original list price

and really has no way of confirming if their

discount has been applied at all. While this

system appears to be legitimate, it fails the

test of commercial scrutiny in that there

is no publicly available (and therefore

competitive) price list and secondly,

customers cannot verify that their discount

is being applied correctly.

the Default PRM

the “default” PRM is simply when the

supplier issues the customer a new price

list whenever they see fit. this approach

effectively abdicates all control over price

to the supplier which is not recommended.

Surprisingly, this approach is quite

common in industry and is by far the best

way to erode any value created from a

sourcing event.

the price of any item consists of several

individual components which typically

have different cost drivers. When

designing a PRM, it is useful to identify

the price components and to understand

the drivers behind them. the goal of this

is to identify suitable published indices

or economic data which directly aligns to

the cost drivers. these data sources can

then become terms in an algebraic PRM.

any price must include the suppliers profit

but most suppliers will not reveal their

profits for obvious reasons and this is

often a sensitive topic. While suppliers will

probably not tell you their profit margin,

they probably will tell you the percentage

split between materials, labour and

overheads. this provides a practical way to

obtain the weightings for an algebraic PRM.

Actual Price Structure

Price Price

$100

Pro�ts 10%

14%

35%

41%

Overheads

17%Overheads

38%Labour

45%Materials

Labour

Materials

$100

Price Structurefor PRM Purposes

Figure 5: Price components for a $100 item

Conclusion

PRMs play a critical role in delivering value

to the business from procurement activities

and are an important supply chain risk

allocation tool. Best practice organisations

take the initiative early and seek to craft

an algebraic PRM in conjunction with

the supplier during the tendering phase.

they aim to create a PRM that allows

the supplier to minimise risk premiums

but also to maintain their margin (but


v. Use publically available indices where possible such as those published by independent bodies such as the aBS

vi. take the time to understand any proposed PRM and the risks being transferred to your organisation – recall that more than two thirds of the contract value is dependent on the PRM

vii. try to match the components of the price to the relevant cost drivers and reject PR mechanisms that are not

directly linked to the cost drivers

viii. Do not accept a simple price list reissue as the default PRM – there is little point in having a contract like this as the supplier is not being held to account or provide value for money

ix. after a price review event has occurred and the supplier issues a new price list, check the new prices to ensure that the maths is correct and that the correct input values have been used

Price

17%OverheadsCost Drivers Suitable Indices

General Information

Wages

Mid steel prices

New price = 100 x 17% x Current PPIPrevious PPI

ABS 6427.0 - ProducerPrice Index (PPI)

ABS 6345.0 - LabourPrice Index (LPI)

TSI Monthly SteelIndex Asia - (TSI)

38%Labour

45%Materials

$100

Price Structure

+ 38% x Current LPIPrevious LPI

+ 45% x Current TSIPrevious TSI

Figure 6: Complete price review example – from the price structure to an algebraic expression

not increase it) over multi-year supply

contracts. the goal of a PRM is a win-win

scenario rather than attempting to “bleed”

the supplier which usually leads to a drop

in quality and service levels or the supplier

even going broke in extreme cases.

in summary, below are a few guidelines on

PRMs which should see you well on your

way to implementing contracts that deliver

value to the business year on year:

PRM guidelines:

i. Where possible, insist on an

algebraic PRM that is expressed as

a mathematical equation with the

initial values specified – not just words

describing the equation

ii. attempt to create an equitable PRM that

allocates risks to whichever party is

best positioned to mitigate them

iii. if an algebraic PRM formula is not

possible, then consider an open book

method but stipulate that all changes

must be mutually agreed and place the

onus on the supplier to justify any price

changes with supporting evidence

iv. Keep an eye out for the various supplier

tactics and strategies outlined in this

paper


about the author

Paul Mazlin

Paul Mazlin leads the engineering and Capital Projects practice at Portland Group and has a background in electrical

engineering and management consulting. Paul has advised clients on contracts that are often in the billion dollar range

for industries such as oil refining, coal seam gas, mining, transport, manufacturing, chemicals, infrastructure, food and

telecommunications

© 2014 Portland Group Pty Ltd. All Rights Reserved. Portland Group, a subsidiary of Infosys BPO, believes the information in this document is accurate as of its publication date; such information is subject to change without notice. Portland Group acknowledges the proprietary rights of other companies to the trademarks, product names and such other intellectual property rights mentioned in this document. Except as expressly permitted, neither this documentation nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, printing, photocopying, recording or otherwise, without the prior permission of Portland Group Pty Ltd. and / or any named intellectual property rights holders under this document.

About Infosys PortlandInfosys Portland is a subsidiary of Infosys BPO Ltd., a part of Infosys Ltd. Our mission is to make our clients successful by increasing their pro�tability through procurement and supply chain improvements. We are unique in providing services to improve e�ciency and e�ectiveness across our clients’ complete procurement and supply chain functions, ranging from innovative, high-end strategy through to e�ective, low-cost operations and transactional processing. The resulting transformational bene�ts for clients include lower costs, reduced risk and improved service from client suppliers.

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